The New Wave in Low-cost Country Sourcing

by By Amitava, Takshay and Rrituraj On Apr 14, 2008

Mathew, a friend of mine, is the procurement head for a major global consumer packaged goods (CPG) firm. And right now he is a much perturbed man. In the last board meeting, his CEO gave him a directive to reduce material costs by 10 percent over the next 18 months. As targets go, this is a pretty steep one, especially considering the fact that most of the spend under Mathew's control is comprised of raw and processed agricultural materials, which have a structured and centralized supply market. Worse still, some of them are highly seasonal in nature, both in time and quantity of marketable surplus.

As my friend summed it up: "Going in and asking for a immediate 10 percent reduction across the board in these sort of markets is a sure shot recipe for supply disruption." All I told him was that he was not alone in his predicament, but there is a way out.

Almost all global CPG firms, particularly those operating out of the Western Hemisphere, are facing the same issue in one form or another. The reasons are not hard to guess: Intense competition from local and foreign firms, ever-rising input costs, the inability to pass on the higher input costs to the consumer, pricing inflexibility and increasing pressure on margins are inveterate truths for CPG firms these days. Organizations, especially those with operating bases in the North America and Western Europe markets, have therefore no recourse but to reduce their input costs, and that, too, on a sustainable basis. This is absolutely critical if they want to maintain a profitable margin level.

For any long-term sustained cost reduction program in a CPG organization, the first port of call is inevitably the direct material spend — spend on raw and processed agricultural inputs, to be specific. This is quite logical since, for an average CPG manufacturer, the direct material cost is approximately 55-60 percent (1) of the total spend (Infosys Research, 2007). Out of this amount, agri inputs account for no less than 55-60 percent (2) (Infosys Research, 2007). Clearly, agricultural raw materials spend form the biggest chunk of the direct material pie and quite logically attract the most focus.

A prima facie analysis reveals several methods that have already been tried out by global CPG companies to curb sourcing costs of agricultural inputs:

Such methods, however, have not produced sustained benefits. Primary and secondary markets (from where most of the raw and processed agricultural inputs are sourced) have established and rather inflexible systems and procedures for trade. Historical evidence shows that implementation of strategic cost rationalization measures have met with determined and sustained resistance in these markets. A case in point: In spite of its obvious business logic, the reverse auction mechanism took close to decade to be acknowledged as a sustainable model for procurement. For North American- and Western Europe-based CPG companies that are facing such adverse sourcing conditions, low-cost country sourcing (LCCS) of agricultural products is an attractive option.

Low-cost Country Sourcing of Agricultural Inputs

LCCS is defined as a procurement or sourcing strategy in which a company sources materials from countries with lower labor and production costs in order to cut operating costs. Up until now it has been profitably implemented by global firms in the IT and discrete manufacturing space. It is only recently that global CPG companies operating from North America and Western Europe have started using it for sourcing of agricultural inputs. The initial step is to identify the "agri commodity" to be sourced and the "source" country. For most LCCS agricultural sourcing operations, the source countries are pre-dominantly from Southeast Asia, like China and India. This is quite logical, since most of these countries are agricultural economies and have significantly lower processing and labor costs compared to USA and Western Europe.

While LCCS sourcing of agricultural raw material inputs is at a nascent stage now, given the significant benefits the process offers it is bound to catch up. A recent study (3) by the Boston-based Aberdeen Group found that CPOs rate low-cost country sourcing as a top priority over the next three years, and that companies plan to double their spending with offshore suppliers by 2008. The report (4) also found that purchases from low-cost countries have average cost savings of 10-35 percent compared to U.S. and Western Europe suppliers.

Sourcing of agricultural inputs from low-cost countries is not without its pitfalls. Supply disruption risk, vendor maturity and control factors are the foremost concerns of organizations implementing LCCS agricultural sourcing. The buyer has precious little control over supply as it comes from a distant source country. Factors like shifts in supply or demand drivers in the source country for the targeted agricultural input, changes in government agricultural policy, modifications in the legal or tax framework, or changes in the crop pattern in the source country can wreck a well-planned LCCS operation. Supply continuity is thus greatly subject to factors well beyond the buyer's control.

An important risk is of the quality of the agricultural input material being sourced.
The issue arises mainly from the nature of the agricultural market. In comparison to manufacturing industries where quality parameters can be laid down in explicit detail (with toleration range), detailing of specifications to a minute level of detail is not possible in agricultural purchase. Local knowledge and decisions based on experience play an important role in determining quality of an agricultural produce. Thus the process of quality assurance is to a large extent subjective and therefore prone to disputes.

There are, therefore two undisputable facts. While LCCS agricultural procurement has immense potential benefits, it also has a plethora of pitfalls along the way. In order to gain sustainable benefits out of this exercise, a framework for low-cost country sourcing of agricultural inputs is required. A comprehensive framework for agricultural sourcing through LCCS will detail the minimum steps and activities that an organization must undertake in order to gain maximum mileage out of this initiative. However, there is one catch — LCCS of agricultural raw materials is very different from sourcing of machine parts and manufactured items from low-cost countries. The proposed model, thus, must take care of the particular nuances in sourcing of agricultural items and the inherent market dynamics.

Framework for Sourcing of Agricultural Inputs from Low-cost Countries

The proposed model delineates a check list of the minimum number of activities that organizations must undertake so as to derive maximum and sustainable benefit out of this exercise. Much like a regular purchasing activity, the model has also been divided into three distinct sections: Figure 4:Model for Low-cost Country Sourcing of Agricultural Inputs (Infosys Research, 2007)

Pre-sourcing Planning Phase

Selection of the agricultural input to be sourced is the first critical step to a successful LCCS operation. Initially, at least, LCCS should only be attempted for those agricultural inputs that have a relatively constant internal demand. There are several compelling reasons for this. For extracting cost benefits out of an LCCS operation, two most vital conditions must exist: internal demand should be constant at least in the short run and supply situation for the targeted agricultural input, in the source country, should be fairly constant. Cost benefits arising out of economies of scale can only be extracted when these two vital conditions co-exist.

Extending this logic a little further, LCCS agricultural sourcing should not be attempted for commodities that have "narrow" characteristics in the source markets, at least not in the initial stages. As stated above, majority of the target markets for LCCS agricultural sourcing lie in Southeast Asian countries. Vital decisions regarding crop patterns and cycles in these countries are controlled by a large, unorganized and disparate farmer base. For these cash-starved farmers, the decision of which crop to grow depends largely on quick returns. For a western CPG company that is unaccustomed to the vagaries of these markets, such drastic changes can greatly hamper their plans for LCCS agricultural sourcing.

Commodity profiling of the targeted agricultural input in the low-cost country is a next essential step. Important computations like historical market price analysis, historical and predicted crop acreage, and crop yield analysis are done in this step, giving a clearer picture of potential gains and the risks involved.

For seasoned buyers, Commodity profiling will inevitably lead to the construction of commodity indexes through which they can simulate multiple business scenarios to arrive at a decision on which commodities to source. A pictorial representation of the commodity sourcing attractiveness matrix is shown here: Figure 5:Commodity Sourcing Attractiveness Matirx (Infosys Research, June 2007).

The axis is modified according to the sourcing prerogatives of the organization. For example instead of business risk, ROI and price pattern could be one set of parameters. Each commodity or a set of commodities are assigned scores on this matrix, and on the basis of the scores the most favorable commodities are chosen. An important issue that must be considered here is the state and direction of the agricultural policy. For example, most of the Southeast Asian countries are heavily centralized in their operations. Governmental intervention is quite high as far as agricultural policy is concerned. In India, open-market sales of almost all agricultural produce are still controlled by some sort of governmental levy that stipulates how much and when produce can be sold in the open market. Careful attention to such nuances will enable the CPG to be prepared for any unexpected change in the supply scenario.

Implementation Phase

Generally, CPG companies, based in North America or Europe initiate a LCCS program for two completely divergent reasons. First it could be a speculative move by the CPG to gain short-terms cost savings for an agricultural commodity with a temporary bull run on the open market prices. In this case, both the time and intensity of the exposure to the local markets of the source country are limited. LCCS agricultural sourcing is simply deployed as a one-off measure designed to give quick, short-term gains.

Second LCCS agricultural sourcing is also being implemented by some CPG organizations as a long-term move — a strategic shift in their sourcing policies. The emphasis is on creating an international purchasing office with adequate systems and policies that will gradually spin off into an independent profit centre.

In either case there are some minimum activities that should be done. The following table delineates both the approach and the steps: Figure 6:Implementation Phase — Activities and Benefits (Infosys Research, 2007).

In speculative LCCS agricultural sourcing, from an overall sourcing framework point of view, it is much better that the scope and direction of the activity is controlled by the sourcing specialists of the CPG. Important benefits include a higher degree of control as well as a lower fixed cost (as opposed to setting up an international purchasing office). Internal sourcing specialists also get exposed to the low-cost country market and are able to learn from and leverage their experiences in subsequent attempts.

In cases of LCCS being implemented as a strategic and long-term initiative by the CPG, it is recommended that an international purchasing office be established. Although setting up an IPO will necessarily entail fixed costs and capital costs, these additional charges will be mitigated by the sustained savings that LCCS will bring. The CPG will also eventually be able to leverage its in-house bank of knowledge and trained personnel to scale up its operations.

A distinct division on sourcing methodologies should be made while implementing an LCCS program. In speculative buying, the focus is on getting the price right and ensuring physicality of the agricultural produce at the destination point. The basic intent is to ensure quick savings and realize the cost savings by ensuring physicality at the end destination. Contracts should have a small time horizon with every effort being made to reduce lead times. It is strongly suggested that CPG global players hedge their bets, at least initially when they are learning the ropes. This hedging can initially be done by holding higher inventory.

If the LCCS exercise is implemented as along-term initiative, CPG buyers must try out their entire arsenal of sourcing methodologies from hedging to backward integration mechanisms in order to gain maximum cost benefit over an extended period of time. In this scenario, the sourcing specialists have the required time and experience to understand, analyze the source markets in detail and determine which of the strategies best fits. However, if an indent-based buying approach is taken in speculative LCCS, then a mismatch between demand and supply would invariably follow.

For procurement intelligence in speculative LCCS agricultural sourcing it is much better that an external agency be hired for the job. The agency will have the advantage of knowing the local conditions, the vicissitudes of local supply and demand, and will be able to leverage existing connections with the vendor base. In the short period of time that speculative LCCS offers, it is neither possible nor desirable for the internal sourcing specialists' of the CPG organization to attempt this.

If a CPG major is initiating a LCCS agro sourcing project for the long term, the exact opposite stands true. In this case, it will be much better for the internal sourcing people to know the local market conditions. The sooner internal buyers get acclimatized to the working conditions of the market, the faster can this initiative start yielding positive ROI. In the initial stages of an LCCS initiative it is proposed that technical analysis of the targeted set of agricultural commodities be done by experts (from the source country), leaving the internal sourcing specialists to focus on the fundamental aspects. This will ensure that the division of labor yields optimum results.

Technology aspects, or the lack thereof, are extremely crucial to consider while implementing an LCCS agricultural sourcing program. In either a short-term LCCS strategy or a drawn out LCCS process, the intention is always to reduce the value chain as much as possible, since as the agricultural product goes up through the value chain it absorbs overhead from all the delivery intermediaries like, processors, wholesalers and retailers. This assumes greater importance in speculative LCCS for three basic reasons. In a speculative LCCS the intention is always to realize cost gains in the quickest time possible, the exposure to the market conditions is low and finally the base on which the variable costs are averaged out is small. Prompted by these factors, an organization implementing a one-off LCCS exercise will approach the primary market in order to profitably source.

Only if the organization is intent on implementing LCCS agricultural sourcing as a long-term strategic initiative should advanced technological solutions like optimization engines, online auction, supplier collaboration solutions, risk mitigation and portfolio procurement software can be used. The costs arising from these initiatives will be averaged out over the large procurement base. Most importantly, it will establish robust sourcing systems and mutually beneficial policies that are essential for a long-term LCCS agricultural sourcing program to succeed.

Evaluation and Monitoring Phase

More often than not, companies pursuing LCCS have found contract management, inward and outward logistics, delivery assurance, quality assurance and delivery assurance as stumbling blocks to their success. Additionally, cultural issues and the makeup of the vendor base (smaller and typically unorganized) often play a major part in determining whether or not an LCCS operation will succeed. Thus, a certain amount of apprehension is quite natural. However, it is the job of the CPG to allay these apprehensions.

One of the most important steps to confident LCCS is the formulation and implementation of clear, concise contracts. Contracts must be comprehensible, transparent, and should include clauses that delineate possible ways out in case of supply disruptions. However, the intent should always be to win the trust and faith of the vendor base and be seen as fair partner to trade. An important factor here is "a single meaning of quality." Continuous training on quality parameters will enable the vendors to appreciate the importance of having a single meaning of quality between two trading partners.

A long-term LCCS sourcing program demands that organizations constantly invest in developing the supplier base and amalgamate them into the current supply chain framework. After the end of a buying season, what was learned from the market on contract compliance, purchase variances against market and budget can potentially form a good basis for the next year's purchase strategy.

Conclusion

Low-cost country sourcing of agricultural inputs is the current phase of the outsourcing phenomena. As more and more CPG companies based in the West feel the heat of increasing agricultural input price they will turn toward countries like India, Malaysia, and Thailand to source their agricultural inputs. However, LCCS agricultural sourcing, like any other cost rationalization measure, is only as good as the results it delivers. Proper implementation, as suggested in this article, will ensure the delivery of optimum results on a sustainable basis.

References

1. Low cost country sourcing strategies for success June 2005, Aberdeen Research
2. Low Cost country sourcing, Its more complex than you think, AMR Research, Dec 2004
3. Tips for Low Cost country sourcing, October 2006, Purchasing.com

About the Authors:Amitava is a consultant in the Retail & CPG practice for Infosys Technologies Ltd. He has over six years of procurement and sourcing experience in the CPG industry. His expertise lies in the spheres of strategic sourcing, procurement planning, and vendor and inventory management. He has a management degree from the Institute of Rural management, Anand. He can be reached at amitava@infosys.com.

Rrituraj is a consultant in the Retail & CPG Practice for Infosys Technologies Ltd. He has over eight years of experience in CPG and retail industry. His expertise lies in marketing, front-line sales management, strategic sourcing, procurement planning, and vendor and inventory management. He has a management degree from the MANAGE, Hyderabad. He can be reached at Rrituraj_Sharma@infosys.com.

Takshay is a consultant in the Pharmaceutical and Supply chain Practice for Infosys Technologies Ltd. He has over five years of experience in CPG and pharmaceutical industry. His expertise lies in strategic sourcing, procurement planning, vendor and inventory management, and various aspects of supply chain management. He has a management degree from the Institute of Rural management, Anand. He can be reached at Takshay_Aggarwal@infosys.com.